Economic and Earnings Downgrades Ahead

Even before the Washington fiasco, earnings guidance has deteriorated (and is now back to early-2009 levels). The outlook has eroded further since the government shutdown started.

The Bullish Market Defense

The principal defense of the markets appears to be that the Fed is going to be easy as far as the eye can see and that interest rates will remain subdued. This, to the bulls, is support for ever-higher valuations (which have already risen from under 14x at the beginning of the year to over 16x today).

Expanding valuations could be the outcome if growth had reached escape velocity and was self-sustaining -- it has not.

The Bottom Line

With all the aforementioned cyclical headwinds and the growth-deflating confusion from Washington coupled with structural challenges to growth (particularly in the U.S. jobs market), I find it hard not to see a valuation contraction. If 2014 S&P profits rise by only 3% (my estimate) and with dividend yields at 2%, a one multiple reduction (which could prove optimistic) in P/E multiples (to 15x) means that the S&P 500 will drop next year.

My out-of-consensus view that bond yields will drop, that economic activity and profits will disappoint and that stock valuations may contract remains in place.

The division between Wall Street (stock prices and valuations marked up) and Main Street (the economy marked down) has grown deeper.

Buy the mystery of the fear over the debt deliberations (last week), and sell the history of their resolve (this week). Or, as legendary trader/investor Joe Gruss once said, "Yell and roar and sell some more."

This column originally appeared on Real Money Pro at 10:29 a.m. EDT on Oct. 17.
At the time of publication, Kass and/or his funds were short SPY, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

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